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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good morning, ladies and gentlemen, and welcome to the Caterpillar 1Q, 2018 Results Conference Call. At this time, all participants have been placed on a listen-only mode, and we will open the floor for your questions and comments after the presentation.
It is now my pleasure to turn the floor over to your host, Amy Campbell, Director of Investor Relations. Ma'am, the floor is yours.
Thank you, Kate. Good morning. And welcome everyone to our first quarter earnings call. On the call today, I am pleased to have our CEO, Jim Umpleby; our Group President and CFO, Brad Halverson; and our Vice President of Financial Services, Joe Creed.
Remember, this call is copyrighted by Caterpillar Incorporated and any use, recording or transmission of any portion of the call without the expressed written consent of Caterpillar is strictly prohibited. If you'd like a copy of today's call, we'll be posting in the Investors section of our caterpillar.com website. It will be in the section labeled, Results Webcast.
This morning, we will be discussing forward-looking information that involves risks, uncertainties and assumptions that could cause our actual results to differ materially from our forward-looking information. A discussion of some of the factors that either individually or in the aggregate could make actual results differ materially from our projections can be found in our discussion of cautionary statements and significant risks to the company's business in item 1A risk factors and the 2017 Form 10-K filed with the SEC, and also in our forward-looking statements included in today's financial release.
A reconciliation of non-GAAP measures be found in this morning's release and is also posted at caterpillar.com/earnings. So we're going to start the call this morning with a few words from Jim, and then Brad will walk us through quarter results and our revised outlook, and then we will turn it back to Kate as we begin the Q&A portion of the call.
And with that I'll turn it over to Jim.
Thank you, Amy. Good morning, everyone. First, I'd like to thank our global Caterpillar team for outstanding first quarter results. I am very proud of how our team capitalizes on improving market conditions to deliver a 31% increase in sales and revenues compared to the first quarter of 2017. Our team also achieved the highest first quarter profit in Caterpillar's 93 year history. We saw strength across many of our end markets in the first quarter including higher demand for construction and mining equipment and for onshore and North American oil and gas applications. We had a great start to the year. But higher sales volumes wasn't the only contributor to this record first quarter results. Operational excellence which includes safety, quality, lean principles and our commitment to control structural costs is one of the three key components of our enterprise strategy.
Our team kept manufacturing cost about flat in the first quarter of 2018 despite a 31% increase in sales volume over 2017 which represents excellent performance by our team. At Investor Day last September, we shared our target operating margin ranges for the company. And for each of business segments, at reasonable sales levels that we've achieved in the recent past. These target ranges represented significant improvement compared to those achieved the last time we experienced similar sales volumes. While operating margins are expected to fluctuate quarter-to-quarter, we are pleased that in the first quarter of 2018, construction industries and resource industries exceeded the targeted ranges communicated during Investor Day.
Energy and transportation operating margin in the first quarter was squarely within its targeted range as was the total Caterpillar enterprise. During the quarter, we made strategic investments and expanded our offerings and services to other two key components of our strategy. As we focus on delivering long-term profitable growth in serving our customers, we will continue to make targeted investments through the remainder of the year. Even with these additional targeted investments, we are raising our full year outlook by $2 per share along with strong first quarter results, economic indicators generally remain positive and our backlog has grown.
Before I turn it over to Brad, I'd like to say a few words about our refreshed cash deployment priorities. As you will see in the slide presentation, we made some changes in support of our enterprise strategy with some things like our commitment to maintain the dividend and a strong balance sheet haven't changed.
We will change how we approach funding growth and share repurchases. Our growth initiatives will be primarily in the strategic priorities of expanded offerings and services not in factor capacity. In the first quarter, we also repurchased $500 million of common stock. Moving forward, we intend to begin the market on a fairly consistent basis to offset the impact of share dilution overtime. We are off to a great start in 2018, but we also have lots of work to do. I am confident that our team will continue to execute our strategy as we move throughout the year.
With that I'll turn it over to Brad.
Thanks Jim. What a great quarter? The strength in the global economy, as well as favorable pricing promote commodities is benefiting many of our end markets. But what is even more exciting is that all the hard work we've done over the last several years to restructure the business, along with our continued cost discipline while investing for growth, helped drive impressive margins, good cash flow and a strong balance sheet. This strategy is delivering and what we intended, driving profitable growth. This morning I am going to walk you through the financial results for the quarter, and our raised 2018 profit outlook. Then I'll take you through our cash deployment strategy that Jim mentioned.
If you'll turn to Slide 4, that's where we'll start. So, I start with the top line. Sales and revenues of $12.9 billion were up 31% from the first quarter of 2017. About half of the increase was in construction industries and we continue to see strength in mining and North American onshore oil and gas for both new equipment and aftermarket parts. I'll walk through more details on sales when we get to the segments slides.
Moving on to the bottom line. We delivered record first quarter profit per share of $ 2. 74 versus $0.32 a year ago. Note that in 2017, profit per share reflected a large restructuring charge for the closure of our gas Belgian facility. Adjusted profit per share of $2.82 in the current quarter was more than double adjusted profit per share from last year on 31% higher sales and revenues.
We ended the quarter with $7.9 billion of cash on hand and repurchase 500 million of the company's common stock. As I said, a great quarter. Let's move on to Slide 5 and we'll review operating profit. First quarter operating profit was $2.1 billion, compared with operating profit of about $400 million in the first quarter of last year. An improvement of about $1.7 billion. Higher sales volume and the absence of the restructuring charge for gas leaks combined with strong cost control as production volumes increased, explained the profit improvement.
The three primary segments saw strong sales growth. Construction industries up 38% with improvements across all four regions. Resource industries up 31%, reflective of a broad industry recovery. Energy and transportation up 26%, seeing growth across all applications. Both strong and user demand and favorable changes to dealer inventories drove the sales volume growth. The favorable change to dealer inventories was primarily driven by construction industries as the factories work to get inventory to dealers in advance of the spring selling season. As you may recall, this is normal activity for the first quarter and we believe dealer inventories remain aligned with current demand levels.
Price realization was favorable $186 million or 1.6%. Manufacturing cost were about flattened a quarter on a 31% sales and revenue growth. Lower warranty expense and a favorable impact from cost absorption were about offset by higher material and freight cost, as well as higher short-term incentive compensation expense. The increase in material cost was driven largely by steel. We expect steel and other commodity costs to be a headwind all year. However, at the end of the day, higher commodity costs benefit many of our customers and they are one of the reasons we have seen several of our end markets begin to recover. Financial products were unfavorable $48 million, primarily due to an increase in the provision for credit losses at CAT financial.
Now let's move on to the segments starting with construction industries on Slide 6. As I mentioned earlier, construction industries drove about half of the sales and revenues growth for the company this quarter. Construction industry's total sales were up 38% to $5.7 billion. Dealers preparing for the spring selling season resulted in favorable changes to dealer inventories. And we believe the increase is supported by current and user demand. Month of sales continues to be low as it relates to inventories as you compare to historical levels. And in China as a result of very high demand, we believe dealer inventories are at levels that are leaner than what will be sustainable.
Additionally, strong global growth improved end-user demand across all regions. Order activity remains strong in the quarter, driving an increase in the backlog. If we look at each region, in North America, dealers prepared for what will be expect to be a strong spring selling season, resulting in favorable changes to dealer inventory. In addition, end-user demand was higher on the strength and non-residential, infrastructure and oil and gas construction activities including the build-out of pipelines. Asia-Pacific saw strength across the region with sales up 46%; about half of the increase was due to higher end user demand in China, which continues to be very robust with growth in building construction and infrastructure.
EAME sales benefit from payroll changes to dealer inventory. A stronger euro and a higher end user demand. Europe is experiencing high business confidence and robust growth, and the commodity producing countries of Africa and the Middle East are experiencing some stabilization, which we believe is encouraging investment in infrastructure and building construction. Latin America while still at historically low levels is starting to improve with sales up 38%, stabilizing economic conditions and improving commodity prices are driving investment in construction activities. Construction industry segment profit of $1.1 billion was about $500 million more than last year, and segment margins improve 4.25 to 19.7%. Higher sales volume and favorable price realization contributed to the profit improvement.
These were partially offset by higher cost for SG&A and R&D, material and freight. SG&A and R&D expenses were up to the higher short-term incentive compensation expense and targeted investments to grow the business.
Let's move to Slide 7. And we'll go through resource industries. Resource industries sales of $2.3 billion increased 31% from the first quarter of last year. This was primarily due to higher end user demand for new equipment across all regions. Strong commodity prices and improve market conditions have improved mining customers profitability. As a result, miners are now investing in replacements for their fleets and initiating mine expansions. And this is driving improved demand for new equipment.
In addition to strong demand for new equipment, demand for aftermarket parts increased as higher production levels resulted in higher machine utilization. Segments profit more than doubled from last year to $378 million and segment margins improved from 9.1% to 16.4%, a significant improvement and above the Investor Day range of 12% to 16%. The improvement in profit was driven by higher sales volume, favorable price realization and favorable variable manufacturing cost, primarily driven by cost absorption. Resource industries discipline cost structure enabled margin improvement. These were partially offset by higher, short-term incentive compensation expense and a slightly unfavorable impact from currency.
Now let's move to Energy and Transportation on Slide 8. Energy and transportation sales of $5.2 billion increased 26% from the first quarter of last year. Oil and gas sales were up $400 million or 50%. Strength continues in North America, specifically for onshore, unconventional oil and gas. While the Permian Basin is the area of highest activity, we are also seeing meaningful activity in other major basins. This continues to drive strong demand for both reciprocating engines and their associated aftermarket parts.
In addition, while demand for new equipment for onshore and offshore drilling remains weak, demand for transmissions, pressure pumps and high pressure flow iron to support well servicing has improved. The delivery of turbines for midstream gas compression to support the build-out of North American natural gas infrastructure remains strong. Sales into power generation were up 35% and improved in all regions. We are seeing demand increases after a multiyear downturn in sales. The largest increase was in the EAME region due to the timing of several large projects and favorable currency impacts. Sales were up in North America from a low 2017 base, due to higher sales from turbines and aftermarket parts sales for reciprocating engines.
New engines and aftermarket sales for industrial applications increased 17%, largely due to improving global economic conditions with Latin America the only region that was not up. Sales in EAME were also positively impacted due to favorable currency impacts.
Transportation sales were up 13%, driven primarily by higher sales in Asia Pacific and North America for rail services. Australia is seeing good growth including from a recent acquisition, and higher rail traffic in North America is driving demand for higher rail services. Marine was up largely due to the timing of deliveries, but the end market especially for offshore vessels continues to be challenged. Segments profit for energy and transportation was $874 million, up about $300 million from the first quarter of last year, and segment margins improved from 13.2% to 16.7%, which is almost in the middle of the Investor day range at lower volume levels.
E&T's profit improvement was mostly due to higher sales volume and favorable price realization. These were partially offset by a higher short-term incentive compensation expense, and some increased spend for targeted investments. Now let's move on to the outlook on Slide 9. With a great start to the year and with the improvements we are seeing in many of our end markets, we are raising the full-year profit per share outlook to a range of $9.75 to $10.75 and the adjusted profit per share outlook to $10.25 to $11.25. An increase of $2 per share more than a 20% raises. If you move to Slide 10, I'll walk through the key elements of the revised outlook.
The increase in the profit outlook is driven by better than expected sales volume. We expect strong economic conditions to continue and for commodity prices to remain at levels that support capital investments. This is driving and improved sales outlook across the three primary segments. We remain focused on controlling structural cost. While we continue to invest in long-term growth initiatives to expand products and to grow services, our assumptions for these cost increases has not changed since our prior outlook. And we remain committed to a flexible and competitive cost structure and keeping structural cost under control. We've recently received lots of questions from investors about potential impacts from higher commodity prices especially steel. The revised outlook does reflect an assumption for higher material cost. However, we have also increased our estimate for price realization, partially due to a mid-year price increase.
We expect this upward revision to price realization to more than offset material cost increases. Also as I mentioned earlier, at the end of the day, we believe higher commodity prices drive improved marking conditions for many of our end markets. Lastly, on the improved profit outlook, we now expect short-term incentive compensation expense to be about $1.4 billion nearly the same as last year. I want to take a second to discuss the implied rest of the year outlook. As you know, we do not give quarterly guidance. The first quarter was impressive with segment margins that were above our Investor Day targets for both construction and resource industries. While we expect strong operating margins for the rest of the year, which is defined as within our better than the Investor Day ranges. We do not expect to repeat first quarter operating margin at the consolidated level.
And let me explain what is driving some of this change. There were several positives in the fourth quarter that we would not expect to continue for the full year. The price versus material cost delta was very favorable in the first quarter, and better than we expected. We expect this delta of price versus material cost to be negative for the balance of the year. However, as I stated for the full year, we expect price to more than offset material cost. Second CAT inventory grew in the quarter to support higher production. Our expectation is that inventory levels will come down which would result in unfavorable changes to cost absorption. And it's often the case the first quarter got off to a slow start for projects spent. We expected targeted investments for future growth to be higher over the remaining three quarters. The outlook assumes that first quarter adjusted profit per share will be the high-water mark for the year.
Now let's discuss the segment sales assumptions moving to Slide 11. For construction industries, we expect sales up across all regions. Strong economic conditions, strength in the oil patch and funding for pipelines and state and local infrastructure investments should continue to drive robust demand in North America. Asia-Pacific should remain robust with China leading the region. We now expect industry sales for the ten ton and above excavator to be about up 30% versus last year. EAME is benefiting from strong business confidence and stability in oil prices. And while Latin America sales are still at historically low levels, economic conditions are improving. For resource industries, favorable commodity prices and positive global economic factors have helped the financial health of our customers and improve business confidence. We expect improving profitability of our mining customers to drive higher capital expenditures for replacements and mine expansions. Strong global economic conditions should support higher sales of equipment for heavy construction and quarry and aggregate machines.
Lastly, we expect production levels for our customer base to be maintained, supporting consistent aftermarket parts demand. Energy and transportation, in oil and gas, stable oil prices should continue to drive strong demand for wealth servicing and gas compression applications and rebuild activity in North America. However, demand for onshore drilling and new offshore drilling and production are expected to remain at lower levels. After a multi-year downturn, we are seeing signs of improvement in power generation, driven largely by improving economic conditions. Good economic growth should also benefit industrial engines and we have increased our full-year sales forecast primarily due to higher projected demand in EAME.
Lastly improvements in North America rail traffic and a focus on growing services is expected to drive improve sales for transportation. However, marine and new locomotives remain challenged. Let's move to Slide 12 and discuss our cash deployment strategy. While not a significant change from previously communicated priorities, there are some differences I want to review. The refreshed cash deployment methodology reflects the fact that our cash priorities will vary from time to time, depending on circumstances and where we are in the cycle. Having said that, we think about it in a following way. Our first priority is to maintain a healthy balance sheet in support of a mid-A credit rating. Next, we intend to deploy to cash necessary to run the business, described here as operational excellence and commitments. Finally, the use of discretionary cash is shown at the bottom of the chart. We intend a fund profitable growth while still returning capital to shareholders. Caterpillar has paid higher dividends each of the past 24 years; sustainable dividend growth remains a very high priority for us. As you saw in the release, we also repurchased about 500 million of common stock in the first quarter.
Our strategy for share repurchases is to be in the market more consistently with intent to offset the impact of dilution over time. In our prior cash deployment priorities, we often viewed profitable growth funding as investments in capacity. As we said an Investor Day, we feel we have the necessary bricks and mortar capacity that we need and expect CapEx to be about $1 billion to $1.5 billion for the foreseeable future. Given our current capacity, we have refocused profitable growth funding to be in line with the new strategy. We intend to fund initiatives that drive long-term profitable growth, heavily focused in the areas of expanded offering and services including M&A where it makes sense.
Now let's turn to Slide 13 for a quick summary before we get to the Q&A. So in summary, sales and revenues were up 31%. We had a record first quarter profit per share and adjusted profit per share more than doubled from a year ago. It's a quarter that all of us are definitely proud of. The strategy is working. We are focused on structural cost control, while investing for profitable growth. And we are delivering significant margin improvements. The balance sheet is strong, cash flow is good and we bought back 500 million of common stock. And going forward, planned to offset dilution over time.
Lastly improving global economic conditions and our continued focus on cost discipline enabled us to raise a 2018 outlook range by $2 per share. We are proud of a high quality financial performance in the quarter. The Caterpillar team has worked hard to reduce structural cost, while investing in the business. And this quarter reflects the fruits of that tremendous effort. As we look forward, I believe the company is focused in the right areas to continue to drive future profitable growth.
With that I'll turn it back to you, Amy.
All right. It's okay. I think we're ready for the question and answer portion of the call.
[Operator Instructions]
Thank you. Our first question today is coming from Jamie Cook. Please announce your affiliation then pose your questions.
Hi, good morning, Credit Suisse. I guess two questions. One some follow-up on your capital allocation priorities. I understand what you outlined but given the lack of internal investment that you need for capacity and you said you'll repurchase shares to offset Cree but it's I mean it's still you're still going to have plenty of cash. So I don't feel like that answers all the questions. So how do you think about a more meaningful share repurchase versus just offsetting Cree and can you talk about your view on M&A and how we should think about larger M&A over the cycle and then my second question given the performance that we've seen in particular on within the construction business and the resource businesses in the quarter, and even last year to some degree, how do we think about the margins in those business longer term given that we're already exceeding the target - your longer term targets that you put out in September. Thanks.
Hi, Jamie, this is Jim. Just starting with an M&A question. So all of our business leaders continually evaluate opportunities for M&A, nothing new so at any one time there's dozens of things we're evaluating. And so again we'll - we're ready to make acquisitions as they make sense for us. We've talked previously about the fact that we are very focused on expanding offerings and services, and that's where both our organic and our external investment will go, that's a big priority for us. In terms of the margin question, certainly we have experienced strong margins in the first quarter. Our goal is to grow the business and we talked in the yesterday about the fact that we are focused on growing absolute OpEx dollars, that's our focus. And so again we want to have a healthy operating margin range, but we really want to invest to grow and that's what we're contending to do.
But just back - sorry on the share repurchase I mean given the pullback in your stock, the numbers that you guys are putting up which are much better than even the targets were that you talked about in September. How do you think about a more meaningful share repurchase?
We don't have anything to announce really at this time. Again, as I said we'll be in the market and consistent basis to offset dilution over time. We don't have any announcements today about any kind of share repurchase.
Thank you. Our next question today is coming from Courtney Yakavonis. Please announce your affiliation then pose your question.
Hi, thanks, Morgan Stanley. Just wanted to get a quick update on your view of commodity inflation. I think you mentioned that those continue to be a headwind and you did raise your expectations in this guidance, but can you just give us a sense of how much you expecting, to higher inflation already in your current guidance? And then a second question if you can just talk about your expectations for China? I think last time you had given us an expectation for about 8% growth. I am just curious if you can give us an updated view there.
Jim, you want to start with my question or would you like to -
Go ahead Amy.
All right. So, Courtney, you're correct, we started off the year expected material costs to be higher. We started to see some material cost increases in the back half of 2017. For the industry, steel prices I think were up about 40% last year. I think they were up about 15% for the industry in the first quarter. We have not seen that type of cost increase flow to through to our results, but we have seen material cost increases most notably for steel continue to increase. And as we said, we now expect material cost increases to be higher for the full year than we thought they would be in the fourth quarter outlook, and that is primarily driven by steel. There are a lot of factors that are driving those steel cost increases, but what we pointed out is that we continue to expect price realization to offset those material cost increases. And in fact, from the fourth-quarter outlook to this outlook, we now expect the price realization increase was actually larger than the material cost increase so that gap grew a little bit, not a significant amount but it did grow a little bit favorable versus what we had in the fourth quarter outlook. And on China expectations, you're correct; we started the year expecting industry demand to be up about 8%. We tend to focus on the ten-ton and above excavator as we talk about specific numbers for industry demand. China continues to be stronger than we expect. We now expect the China 10-ton and above excavator demand to be up 30% this year. At that level that's about 88,000 excavators for the industry, that's probably about 20% to 25% above where we think normal replacement demand and the macro environment in China supports. But we do at this point continue to expect China to be very strong for the rest of the year. That said, we expect normal sales patterns in China, so we expect about 60% of end-user demand to come in the first half of the year, and about 40% of end-user demand to be in the back half of the year.
Thank you. Our neck question today is coming from Ross Gilardi. Please announce your affiliation then pose your question.
Hey, Bank of America Merrill Lynch. Hey, good morning ,everybody. So I just want to ask you about this mid-year price increase. Our competitor is matching it and how are you presenting it? I mean it's a cost-push price increase or is it just because demand is so strong right now and you end up in a situation where you feel pressure to lower price if your input costs go down?
So, Ross, there's a lot of factors that go into pricing. Certainly key to them is our strategic initiatives and our focus on profitable growth. We began mid-year price increases several months ago discussions around what was appropriate and the market environment that we're seeing today. And the mid-year price increase which is primarily for construction industries products and some resource industries products that are largely used in heavy construction activities is where we took that major price increase.
And this is Joe, this is when it was a modest increase and I wouldn't view it as a surcharge that would drop it based on commodity prices or anything.
What are you seeing competitively, Amy? Are you seeing other OEMs do the same thing?
Yes. So I mean I think we're only feeling appropriate to talk about our actions. We certainly read the same information that you do, but I think it's only appropriate at this time to talk about our pricing actions not those of others.
Okay, fair enough. And then just about mining aftermarket. I mean you had just a huge year last year. Obviously your results improve quite a bit in the segment but seeing any signs to slow down in spare parts demand from mining equipment as rebuild activities already been completed and any more granularities you can provide on kind of a new equipment environment?
Sure. So the short answer is no. We're not seeing any slowdown and aftermarket parts demand for mining. We continue to see robust rebuild demand; strong utilization in the mines is driving improving aftermarket parts demand and orders. So we expect increases in aftermarket parts for the full year 2018. However, we are expecting even from a percentage basis more significant increases and new equipment for mining. So after several years of underinvestment and replacement demand and some new mining expansion, we expect new equipment sales to grow by more than aftermarket parts sales this year.
Thank you. Our next question today is coming from Seth Weber. Please announce your affiliation then pose your question.
Hey, good morning, it's RBC. I actually wanted to follow up on the resource margin question a little bit more. So profits were up basically double on kind of flattish revenue sequentially. And I'm - I think what I heard you say was that the first quarter had more equipment sales, that equipment sales were particularly strong in the first quarter. So I'm just trying to tie a lot of this stuff together with kind of margin trajectory for the resource business, just the big ramp that we saw in the first quarter versus the fourth quarter. And then just kind of - while I guess addressed the mix going forward but should we still expect margin expansion from the first quarter level I guess my question.
Yes. So a couple of things in there. The resource margin largely driven by volume increases. So resource industries saw a 31% volume increase driven by higher end user demand. That was the biggest driver. They also had some favorable price realization and really kept their cost relatively flat on that significant volume increase. So that drove a lot of margin improvement. One thing that we point out at the consolidated level that's impacting resource industries margins as we move throughout the year is cost absorption. So resource industries saw a significant increase in inventory in the quarter, which had a favorable impact to their margins and to their performance in the quarter. They now expect their inventory to be about flat for the rest of the year, which will have a negative impact and cost absorbs and for the remainder of the year. So a resource industry does expect their margins to come down from the first quarter, but to remain within the Investor Day range for the full year. And at resource industries volume levels, a few changes like cost absorption can have a meaningful impact in margin performance but for the full year we do expect resource industries to be within the Investor Day range.
Okay, that's helpful, Amy, thank you. And then maybe just a quick follow-up on the Finco. It does sound like some of the metrics did tick up here and I think you called out power, CAT power finance and some other Latin American business, is that isolated project activity or can you just give us any more color what's going on there?
Yes. So CAT financials normal business in the quarter was quite good. Average assets were up, margins expanded. There was some weakness in the CAT power finance and LATAM portfolios as you discussed, and even in the CAT Power Finance, a significant portion of that was in Latin America. So it's a reflection of some weakness in Latin America that we all are well aware of and has been there for some time putting some pressure on that portfolio. There are also some unique just financing rules and issues in LATAM about being able to get inventory back and how you process through past use. And so overall, no, it's really mostly very specific to Latin America and the weakness we've seen in the recent past in that economy. And outside of that it was really just one or two customer issues that were going through some financial challenges and had some restructures to their loans.
Thank you. Our next question today is coming from David Raso. Please announce your affiliation then pose your questions.
Hi, Evercore ISI. Just a clarification I think you mentioned first quarter EPS would be the high-water mark for the year by quarter. And I'm just trying to make sure I understand, in the last 20 years your second quarter has always been above your first quarter except for twice, right, when oil and gas was rolling over in 2015 and in 2011 when Cyrus and the Japanese disaster hit the quarter. So kind of unique circumstance. and I know you just commented a bit on resource but can you help us understand a little more the puts and takes on why such an anomaly of the first quarter being a high-water mark? The idea the investments might be interesting if you can maybe flush out some numbers around that, the price costs won't be as positive as the first quarter, but as you said if anything for the full year, your view even get a little better for price cost, now maybe a lot of it was in the first quarter already, I appreciate that but I'm just making sure we understand why such anomaly that the second quarter is below the first quarter.
Yes. So there are three reasons why we see the first quarter profit per share to be the high-water mark and you mentioned all three of them. I'll go through them again. Price versus material cost, very favorable on the first quarter. We expect to be favorable for the full year but for the balance of the year we would expect material cost increases to be greater than price realization.
And Amy if I can stop you there for a second, if I'm seeing a waterfall chart right, price realization with healthful manufacturing costs for a positive 207, is that the right way to read it on the consolidated operating profit, the waterfall chart?
So we've got price realization I think was $186 million in the quarter
And the cost were positive 21 so called it 207. So if you think a full-year still positive. It can't take out more than $207 million. So I mean its $50million, $60 million a quarter drag. So that's $0.06. I'm just making sure I understand where are the magnitudes to create such an anomaly in your seasonal pattern of earnings.
Yes. So manufacturing costs, a significant piece of that favorability was cost absorption. So with the inventory growth in the quarter which I believe was $900 million or so that drew favorable cost absorption. We do not expect that - we expect that to actually be an unfavorable item for the balance of the year. So it is there --there is negative material cost and that manufacturing cost bucket and favorable cost of absorption that will not repeat itself. In addition to that, we do talk about period cost spend which is twofold. One is just normal seasonality of spent. So the first quarter is often a slow quarter for project spending as R&D projects pick up throughout the year? And then many of our target initiatives for e-commerce, for digital, for expanding products like the NextGen got off to a slower start than we expected, and we expect those projects to get back on track as we proceed throughout the year.
And can you flush that last part out. Is the other part about starting year slowly and ramping up that's part of the normal seasonal pattern we've seen? So that doesn't answer the anomaly question. The target investment so it could be helpful. Can you give us some order of magnitude on how big these target investments ramp up as the year goes?
I don't have a specific number to give you, David. I mean what we did talk about is that we did not change our estimate for those for the full year, but we got off to a slow start in the first quarter. So we kept our fourth quarter outlook for investing and those target initiatives are the same but under spent on those in the first quarter.
Okay. There's not - if there's nothing else to point at that, that's helpful, I appreciate the feedback. It just seems a bit of an odd - an odd seasonal I mean it just seems the last two times we've had the first quarter be even this low percent of the full year guide. You kind of have to go back to paying, we were peaking in early 2012 and we rolled over by the end of the year or oil and gas started to roll over in 2015. I'm just making sure we all don't walk away saying hey that was the best quarter they're going to give us period. Is that the only the time that's happened is we peaked in early 2012 and oil and gas hit us broadly in 2015. So I'm just being clear with what you are trying to communicate.
Yes. So very clearly we are trying to communicate that we see strong demand across all regions and most of our end markets increasing from our fourth-quarter outlook. And so driving the first quarter raise is an increase in our sales volume expectations which implies that we see continued good growth for the balance of the year.
Thank you. Our next question today is coming from Ann Duignan. Please announcer affiliation then pose your questions.
Hi, good morning, JPMorgan. Can I just take a step back on the price cost comments that you made. I just want to make sure I understand did you specifically say the price cost will be a negative for the remainder of the year for each of the quarters? And, if so, since you're pushing through a price increase in an environment where backlogs are very solid why wouldn't you push through a price increase sufficient to offset input costs and what does that mean for 2019 if we're behind going into 2019?
So a couple things. Yes, you're correct that we said that for the balance of the year price versus cost would be negative. We don't give quarterly guidance. In fact, I don't have the breakout of what that will be quarter – by quarter, but for the rest of the year that comparison will be negative and certainly as we sit here today at the end of the first quarter, we're a long way from looking out into what 2019 will look like. And we do and Brad said this a couple times in his script continue to stress that at the end of the day higher commodity prices are a good thing for our end markets. And we're seeing that translate into improvements across many for many our customers. As far as the price question, we have good margins, it's a competitive marketplace, continues to be a competitive marketplace. And at the key point of our strategic strategy is to profitably grow the business.
But just then as a follow-up on the backlogs could you just talk about mix in your backlogs by segments? I know you did address resource but are there any positive or negative kinds of product mix in the backlogs that we should be aware of as we look at the remainder of the year? Thank you/
Sure. So the growth in the backlog was driven by construction energies and energy and transportation, resource industries backlog was flat and sequentially from the fourth quarter of 2017 driven really by two things. One, we had a very strong order board in the fourth quarter. We saw some of those orders-- we didn't - so I guess I would say it that way we saw a very strong fourth quarter and then velocity for shipment really picked up in the first quarter. So we were able to keep up with orders and get throughput and shipments out the door. Construction industries backlog increase is reflective of continued strong demand and construction industries. And I say the same for energy and transportation, the biggest piece of that for reciprocating engine largely for North America onshore oil and gas. And I know there's always a lot of interest, so our backlog remains healthy and was flat - about flat sequentially from the fourth quarter to the first quarter.
And just quickly on construction. Any change in mix of the backlog more compact, more large not anything we should consider that would negatively or positively impact mix?
Yes. I would say broadly speaking that we're not seeing much significant mix impact across the segments in our outlook. It's not an area that we're focusing on really positively or negatively. It's over the entire portfolio is pretty balanced.
Thank you. Our next question today is coming from Jerry Revich. Please announce your affiliation then pose your question.
Hi, good morning, it's Goldman Sachs. I'm wondering if you could talk about your expectations of period costs over the course of this cycle over your prior recoveries around year two, year three was when we would see period costs really move higher? I'm wondering if you can counsel somehow to think about it given a difference in the approach to CapEx and post restructuring is this level of period cost performance that you put up in the quarter sustainable?
This is Jim. So, Jerry, we are certainly committed to controlling structural cost as we've said many times. We are going to making targeted investments and those are in the areas of expanded offerings and services. And so in the past when we wanted to grow was through either R&D for new products, we build the factories or we make an acquisition. So now we're really looking at in making some investments again in services. We're expanding our digital capabilities and so some of that will involve period cost, period cost but again we're very committed to keeping our structural cost under control. So I think I answered your question but again we'll make some targeted investments, but we're not, just don't let cost creep up the way they have in the past.
And Jim the returns profile of those investments over what period do you expect an ROI? Is it a long-term strategic type of investment that we should be thinking about or is it more quick hitting within two years we'll see the earnings benefit of any related period investments?
Yes. There isn't one answer to the question. So for some of them that would be a longer term and for some they will be relatively short. So again as we focus on the aftermarket generally many of those investments should produce relatively short-term returns and some will be more long-term.
Okay and then structurally how do you think about your expected level of dealer inventories in this cycle? If I have it right I think your dealer inventories are down half a month to a month from the last cycle. Is that the level that you expect to see in this cycle? Can you just put that into context for us considering how much dealer inventories can move early in the year?
Yes. So, Jerry, maybe I'll step back a little bit, dealer inventory levels in terms of months of sales are at the bottom end of our current range that we think about, but keep in mind that dealer inventories are controlled by the dealers or independently owned and operated. So ultimately they have the decision power there. But we have moved I would say from a targeted range for dealer inventories in terms of months of sales from three and a half to four months of sales down to about three to three and a half months of sales. So as you hear us talk about that it probably is lower than where we were in the prior cycle. Right now we're at the bottom end of that range and in some regions most notably in China were actually well below that range, and we expect at some point I guess over the long that won't be sustainable, we'll have to see some dealer inventory come back into or Chinese dealers.
Thank you. Our next question today is coming from Rob Wertheimer. Please announce your affiliation then pose your question.
It's Melius Research, thank you. The question is just a philosophical one I guess for Jim on margins. How did you think about setting the margin targets that you did at the Investor Day? And I assume that you think you can grow profitably and maybe even gain share at those target levels. How do you think about - is you as you achieve - as you have really exceptional results whether you let them drift above that cyclically or not, we're at low cycle or mid cycle now. And where they'll just above or not and how you think about competitiveness and balancing what margin you take? Thanks.
Yes. So it certainly as a balance. So to answer your first question how do we establish the margins? We looked at the margins that we achieved at similar sales levels in the recent past and we put forward what we thought was a reasonable expectation for our teams to improve margins. Now as we've said, again both this morning and in Investor Day, our goal is to profitably grow and we want to make investments to grow within a healthy range. We're not too concerned about quarterly deviations because we expect quarter to-quarter that there'll be some movement there, but again we're trying to grow the business over the long term in a healthy margin rate.
And then you - I assume you think you can grow share a little bit in those ranges and would you let margins drift above that if we had cycle volumes at some point. We should have been obviously?
Yes. It is a balance and obviously one of the things trying to do is grow the aftermarket and have aftermarket you need to have market share of new equipment. So it's always a balance that we - there's no one answer to the question but yes we want to increase share we do, and it's always a balance between margins and share, but again our goal here is to grow the business.
Thank you. Our next question today is coming from Joe O'Dea. Please announcer affiliation then pose your questions.
Hi, it's Vertical Research. First just back on dealer inventory and when you look at the $1.2 billion of build in the quarter and it sounds like that's primarily expected to go to end market demand this year. So are you looking at no net build and dealer inventory? And then if that is the case where would you be on inventory to on months of inventory as you get to the end of the year?
Yes. So your assumption is correct, Joe. We expect dealer inventory to end the year about where we are now at the end of the first quarter, maybe up or down a little bit, but I think broadly speaking to end the year pretty close to where we ended the first quarter. We do expect construction industries dealer inventory come down in the second quarter on a strong selling season. And at the same time, we expect resource industries dealer inventory to come up in the second quarter on continued kind of build out and support of strong demand and user demand for resource industries. And then for that inventory to again come down by the end of the year. I don't have an estimate a month of sales for the end of year, and quite frankly as we all know ultimately where we in dealer inventory will have a lot to do with the 2019 outlook is. And we're not giving that today, and so I think kind of estimating what months of sales will be and frankly well I walk through what our outlook includes exactly knowing where dealer inventory will be at the end of the year. It's a lot to do with where dealers are and where an expectation for 2019 for the dealers comes in it.
Okay, thanks. And then on mining equipment and you're talking about seeing demand both on replacement as well as initiated expansions. And I guess specific to the expansions, given the amount of equipment that was sold in 2011 and 2012, so I'm thinking that there's enough equipment on the sidelines that it can come back into service for a while. But where are we there? Are we had a point where through cannibalization and the amount of equipment that's back in service that we're getting to more normalized levels of parked fleet and that from here we're looking at needing OE to serve that demand? Just kind of a status update on un-parked fleet and the drivers of that new equipment demand?
Sure. So the parked fleet does continue to come down, rebuilds remain robust. We expect them to be robust throughout the rest of the year. So I would say that there are still trucks that come back online in our estimation. It has - there's a lot of complexities about bringing the parked fleet online versus expansions where's that parked fleet add versus where are the expansions in mines at, and there are so many things driving new equipment demand expansions being one, but also replacing equipment which has been delayed for some time now also being a significant driver of new equipment demand. And so we do - I think in short we do have the parked fleet continuing to come down, rebuild, driving and aftermarket parts sales continues to be robust. And where that new equipment is I guess kind of in short term it's pretty broad around the globe and pretty broad by commodity. So the recovery in mining that's occurring continues to be pretty broad-based.
Thank you. Our next question today is coming from Andrew Casey. Please announce your affiliation then pose your questions
Wells Fargo Securities, good morning, everybody. I just want to make sure I'm understanding some of the messaging coming out of this call because during the call the stocks kind of sold off quite a bit. You're kind of pulling back expectations on share repurchase and yet it seems like you're going to be generating quite a bit of cash through the year especially given the implied inventory drawdown. What are you looking to use that cash for? I know you've identified that the deployment options. Are we - should we kind of walk away from this call looking like you're a little concerned about peak or are you looking at an evaluating an active pipeline with an M&A? And if so, could you please share a ballpark average deal size you might be contemplating?
And this is Jim. So it certainly wasn't our intent to express a concern about peak to use your words, really no change here in terms of us continually looking at M&A opportunities. Obviously, our cash position has improved over the last year and that allows us the flexibility to make investments both organically and in M&A. And again, we're not ruling anything out. So I said about share repurchase we didn't have an announcement to make today. And again, we're looking at staying with our strategy to grow our business as we communicated in Investor Day.
Yes. This is Brad. So my guess is you guys are modeling and you see potentially some strong cash flow moving forward and want to know what we're going to do with it. And I think what Jim has says we're going to continue to invest in the business, may be different than the past we're going to be in the market in a more continuous basis for stock repurchase to offset dilution. We are continuing to look to grow and do the M&A business. I think what we're saying is that we're not going to answer that question right now that you have potentially on your mind as to what we would do with the excess cash that could happen down the road. We're not saying it wouldn't be a repurchase; we're just not answering it right now.
Okay, thank you. And then one last question as this gets to the cycle for a business that's enjoying some really strong demand trends. If we look at construction industries and exclude the China market could you kind of give us kind of a ballpark range maybe percentage or however you want to potentially answer it, where is construction industry unit volume relative to peak if we exclude the China market?
So, Andy, I don't have that number off the top of my head. I think if you look - you have to look market by market, North America is doing strong but I think one could argue we're just starting to see healthy new home constructions, infrastructure remains far below potential. LATAM is just starting to recover and is well below the sales levels that it was a few years ago. And you could say the same thing about Europe which has been strong from some time now, but in total is far below where sales were in Europe decades ago. I mean EAME portion, of EAME have seen some weakness in the last few years, and they're starting to see a little bit of turnaround and improvement as well. So I think it is a different story across the different regions of construction industries, region like China we've been pretty clear. We think is quite robust and above where we think normal robust demand, another region like Latin America is still from a historical perspective at very low levels. With that I think that needs to be the last question. Kate?
Thank you. Do you have any closing comments you'd like to finish with?
Yes. Appreciate everyone calling in today. We appreciate your questions and look forward to chatting with you next quarter. Thank you.
All right.
Thank you, ladies and gentlemen. This does conclude today's conference call. You may disconnect your phone lines at this time. And have a wonderful day. Thank you for your participation.